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SEC Report Recommends No New SOX 404(b) Exemptions

An
SEC study of Section 404(b) of
the Sarbanes-Oxley Act recommends
no new exemptions to the requirements.

The
study by the SEC’s Office of the Chief Accountant was mandated by
the Dodd-Frank Wall Street Reform and Consumer Protection Act. Its
scope was restricted to companies with a market capitalization
between $75 million and $250 million.

The
findings, released Friday, recommend maintaining
existing requirements of Section 404(b) for accelerated filers in
general. It also calls for actions “that have potential to further
improve both effectiveness and efficiency of Section 404(b) implementation.”

The
404(b) requirements, which focus on the auditor’s report on internal
control over financial reporting, have
been in place since 2004 for domestic issuers and 2007 for foreign
private issuers. In
June 2007, the PCAOB issued Auditing Standard no. 5, An
Audit of Internal Control Over Financial Reporting That is
Integrated With An Audit Of Financial Statements, to address
the costs in conducting an effective audit of internal controls and
feedback on 404(b).

Dodd-Frank
tasked the SEC with
determining how the Commission could reduce the burden of complying
with Section 404(b) for smaller accelerated filers, while
maintaining investor protections for such companies. It also
required a review of whether a complete exemption for such companies
from Section 404(b) compliance would encourage companies to list on
U.S. exchanges in their initial public offerings (IPOs).

“The
Staff’s analysis shows that the United States has not lost
U.S.-based companies filing IPOs to foreign markets for the range of
issuers that would likely be in the $75-$250 million public float
range after the IPO,” according to the study. “While U.S. markets’
share of world-wide IPOs raising $75-$250 million has declined over
the past five years, there is no conclusive evidence from the study
linking the requirements of Section 404(b) to IPO activity,” the SEC
staff concluded.

The
study addresses the auditor attestation requirement with respect to
an issuer’s internal control over financial reporting (ICFR)
pursuant to Section 404(b). It does not address management’s
responsibility for reporting on the effectiveness of ICFR pursuant
to Section 404(a) of the Sarbanes-Oxley Act.

Based
on its review of prior academic and other research on Section 404,
the SEC study drew four conclusions:

The
cost of compliance with Section 404(b), including both total
costs and audit fees, has declined since the 2007 reforms under
AS 5;

Research
has found no conclusive evidence linking the enactment of
Section 404(b) to decisions by issuers to exit the reporting
requirements of the SEC, including ICFR reporting;

Auditor
involvement in ICFR is positively correlated with more accurate
and reliable disclosure of all ICFR deficiencies, and
restatement rates for issuers with the auditor attestation is
lower than that for issuers without this attestation; and

Disclosure
of internal control weaknesses conveys relevant information to
investors.

In
its recommendations section the report states that at the request of
SEC Chairman Mary Schapiro,
the SEC staff “is taking a fresh look at several of the Commission’s
rules, beyond those related to Section 404(b), to develop ideas for
the Commission about ways to reduce regulatory burdens on small
business capital formation in a manner consistent with investor
protection. However, the Dodd-Frank Act already exempted
approximately 60% of reporting issuers from Section 404(b), and the
Staff does not recommend further extending this exemption.”

The
report suggests that the PCAOB consider publishing observations,
beyond those previously published in September 2009, on the
performance of audits conducted in accordance with AS 5. These
observations could help auditors in performing top-down, risk-based
audits of ICFR, the report states, and could highlight lessons that
can be learned from internal control deficiencies identified through
PCAOB inspections.

The
SEC staff is also monitoring COSO’s work to review and update its
internal control framework, which “is the most common framework used
by management and the auditor alike in performing assessments of
ICFR,” the report states.

The
study’s analysis of prior research found, among other things, that:

More
internal control weaknesses were discovered by the auditor (or
auditor and client jointly) and by control tests rather than
substantive tests.

Disclosures
of material weaknesses under Section 302 were more likely in the
fourth quarter when auditors were on-site at the client’s office
most frequently and when the audit firm or office had experience
with Section 404 audits

The
majority of internal control deficiencies that were classified
by the auditor as a significant deficiency or a material
weakness were initially classified by the issuer as less severe.

The
following statement was released Monday by Cindy
Fornelli, executive director of theCenter for Audit Quality, an autonomous public
policy organization affiliated with the AICPA dedicated to enhancing
investor confidence and public trust in the global capital markets:

“I am
pleased that the SEC’s Office of the Chief Accountant’s thoughtful
study recommends retention of Section 404(b) of the Sarbanes Oxley
Act for companies whose market capitalization is between $75 and
$250 million. Section 404(b) requires independent auditors to attest
to management’s assessment of the effectiveness of its internal
controls over financial reporting (ICFR). The study concluded that
costs of Section 404(b) compliance have declined and financial
reporting is more reliable when the auditor is involved with ICFR
assessments. Importantly, the study found that investors generally
view the auditor‘s attestation on ICFR as beneficial. Finally, we
are happy to see that there is no conclusive evidence linking the
requirements of Section 404(b) to listing decisions of the studied
range of issuers.”

“The
CAQ, joined by the Council of Institutional Investors, filed a
comment last September with the SEC fully supporting retention of
404(b). We hope this study will effectively discourage further
discussions around ways to dilute the investor protections contained
in Sarbanes-Oxley,” Fornelli said in the statement.

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